Golden lust

A file photo of a jewellery showroom in New Delhi. Photo: Priyanka Parashar/Mint

Updated: Wed, Jan 23 2013. 07 34 AM IST

India raised import duties on gold to 6% from 4% to restrain its current account deficit, which is spiralling out of control. At 5.4% of gross domestic product (GDP) in July-September 2012, it is the country’s biggest vulnerability besides being an enormous strain upon the currency. The deficit may yet widen to 4.8-4.9% of GDP for the year to 31 March from last year’s 4.2%, indicating its unsustainable trend. Gold imports, on a rampage for four successive years, are in focus again to tame the current account deficit as exports decline sharply.

Yet curbing gold demand hardly resolves the current account deficit problem, which is more driven by a persistent widening of the trade deficit and inelastic demand for some imports. As past experience shows, higher import duties are not even a short-term solution: duty on gold was raised from 2% to 4% in March 2012, upon which gold import volumes fell somewhat but rose sharply in July-September. The current account deficit expanded nonetheless. Reduced gold demand may shrink it by just 0.2-0.3 percentage points, leaving the problem unaddressed.

Curbing gold demand through controls dodges its real cause as well. Why is the Indian consumer obsessed with gold in the first place? The near-perfect correlation between consumer inflation and gold demand in the last four years provides the answer. Gold is simply an asset to deploy capital and safeguard its value in a high inflation environment. It is also under high inflation that governments resort to controls to discourage people from holding alternative assets: in hyper-inflation countries like Argentina, it has been foreign currency, or dollar, holdings and in India, where people cannot substitute local savings with foreign substitutes, it is gold. With negative real interest rates for most part since 2009, holding physical gold has proven the best alternative investment for households, whose holdings have now reached nearly $1 trillion. Other than providing returns, gold is liquid and convertible, which matters when the currency isn’t and is moreover, depreciating fast too. Gold is also the best option for storing illegal wealth in an inefficient tax system; it leaves no paper trail. And unlike land, another hedge against inflation, it cannot be confiscated. In sum, it is a winning strategy to the end when inflation is well-entrenched.

The policy response of higher import duties also serves to create another distortion. Much like the dual pricing introduced for diesel sale last week, higher duties upon gold will merely ignite an illicit channel for gold imports. Lasting solutions instead would be to lower inflation, provide better options for financial savings along with monetization of physical gold, on which a recent Reserve Bank of India report offered suggestions.

Renu Kohli is a New Delhi-based macroeconomist; she is currently Lead Economist, DEA-ICRIER G20 Research Programme and a former staff member of the International Monetary Fund and Reserve Bank of India.